Tuesday, April 27, 2010

Levin vs. Blankfein Faceoff

Some quick observations on the performance of Goldman Sachs' CEO at the roasting before Congress today:

1. Blankfein technically outpointed Senator Levin during the opening exchange, I think -- Levin doesn't have a particularly deep understanding of high finance -- but Goldman's chief lost the big point: how Goldman's actions appear to Main Street. Basically Blankfein condoned the practice of "betting against a product you're selling." That's the damning headline. Here's what it sounds like to Joe Blow: I sell you my car, and meanwhile, I bet with someone on the side that the car will break down within six months. No graceful way to put lipstick on that pig.

2. Notice how often Blankfein used the phrase "market maker" when facing off with Levin? Nice defense except -- Levin wasn't really interested in being tutored on what a market maker does. Levin was too busy cudgeling the head of the investment bank with the "conflict of interest" point. Main Street doesn't understand "market maker." It does, however, understand quite well "conflict of interest."

3. Is the successful beating up on Goldman a sign that the investment banks have been hoisted on the petard of the complexity they nurtured? They produced synthetic CDOs that the rating services couldn't understand and mis-rated; these same synthetic CDOs were so complicated, with so many sliced and diced mortgage-backed securities underlying, that arguably the disclosure standard should have been higher than normal, even for sophisticated investors; "synthetic CDOs" are raising a lot of eyebrows among members of Congress who are wondering -- "What the hell is the point of something that's this damn confusing? There's got to be a rat in this woodpile."

4. Senator McCaskill scored points, along with McCain, by noting that with a synthetic CDO, there's no real there there. It's just a side bet on actual assets that have already been sold, so you're not actually buying anything concrete. McCaskill shook her head in befuddlement before saying, "seems like a hamster in a cage trying to get to compensation." Blankfein defended the product with some mumbo jumbo about managing risk profiles. But what we're left pondering is McCaskill's image of hamsters manically tunneling through the wood chips for dollar bills.

5. Is Blankfein this dumb, or did he have a convenient "idiot" moment: Senator Pryor asked him about structured investment vehicles (actually, Pryor used clumsier wording, and then Blankfein hastily corrected him, knowledgeably saying "structured investment vehicles.") And then Blankfein goes completely ignorant, it seems, when asked why the bank would use an SIV. His reply: "I'm not sure." (Cue laughtrack at home.)

Ah, a little more cathartic financial-crisis theater ...

Monday, April 26, 2010

Financial Reform: Unsung Proposals that I Wish Were on the Table

We will be getting reform, and soon, it appears. Mike over at Rortybomb nicely table-izes six big areas/rules/issues to watch as legislation takes shape.

Maybe I'm just getting jaded, but what's on the table doesn't excite me much.

Transparency in derivatives through exchange trading? Yes, deeply important, but lobbyists will probably carve out small exemptions that Wall Street banks will then funnel as many of their trades through as possible. Too big to fail? Yeah, sure, cut 'em down to size, but Krugman is right on this one. Smaller banks, sufficiently interconnected and freighted with risk, can haul down the system too.

Hard leverage cap? I wholeheartedly support limiting leverage, but remember: leverage is a number. As Repo 105 and the continual perversion of accounting for capital under the Basel Accords show us, annoying numbers can be massaged. So under a hard leverage cap, I predict an explosion in "leverage-friendly financial innovation." Just wait.

So what is there to do? It won't happen during this round -- maybe the system has to seize up again, horribly, in the next few years -- but I wish we would look more at meta-type solutions. Here are some unsung proposals that I wish would get more consideration:

1. Contingent debt. This comes from the Republican side of the aisle, and though I confess to not having studied in great detail how the idea would work, I like the gist of it: banks hold a chunk of bonds that, when they come under duress, automatically convert to equity, boosting their cushion of capital. The percentage of such debt could be adjusted, if need be. The concept is market-oriented, as investors help police the institution's risk-taking. As Greg Mankiw writes:
This contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.
2. Financial transaction tax. I know, I know: to have efficient and liquid markets, you want participants to be able to trade as freely as possible. But I think that, sometime over the last decade or two, the amount of trading vaulted through the point of maximum efficiency and into something else -- something born of supercomputers run amok that just encourages volatility and instability. We need to slow down the financial machine a little. A small tax might encourage the bloated financial sector to shrink a little (a good thing) and raise money for our deficit (also a good thing).

3. "Deep clawback." Misaligned incentives are clearly an issue. And there'll be some feeble attempts to better align pay with long-term performance, but little will probably change. What we need is a way to get deeper into the pockets of bank executives and directors who allow their companies, through negligence or a desire for risky growth, to spin out of control, endangering the financial system. It sounds radical, but let's consider putting their personal houses and cars on the line -- or at least make them easier to prosecute criminally. Then behavior will change. If bankers hate "deep clawback," there's an alternative: Regulate the financial industry like a utility.

4. Move away from a rules-based to a principle-based system. This would be tremendously useful. With a squadron of lawyers and accountants in tow, every major Wall Street bank knows how to game and evade and twist every single rule that's been thrown at them. They will ALWAYS beat a rules-based system. But what if, in certain places in our laws, we used the language "what a reasonable accountant would ..." or something similar? This would stop them dead in their tracks. Because then they can't simply say in defense, "Well, you don't explicitly prohibit what I'm doing, so it must be okay."

So those are some of my favorite ideas that aren't seriously part of the discussion, unfortunately. We will get reform. It may not be that impressive. But if the financial system blows up again -- and relatively soon -- someone in Congress may get the idea that what we really need is more meta-reform -- and less tinkering around the edges.

Saturday, April 17, 2010

The Goldman vs. SEC Story That No One Has Written ...

When I saw that the SEC had finally decided to go after Goldman Sachs, I immediately rejoiced: Yes. At last. What the hell took you so long?

Then, when I started sifting through the strange case of Abacus 2007-AC1 (fairly trips right off the tongue eh?), I had a "pullback" moment, especially after seeing Goldman's defense (see the bottom of the page).

First, I have no love for Goldman. Far from it. I think it's rather creepy the way they release their ideological spores throughout our political system by practicing "civic responsibility" and occasionally shipping a handful of executives off to the Treasury Department, to keep the U.S. approach to the financial system appropriately capitalist at all times. But this Abacus case -- ah well, it doesn't make sense, unfortunately. I think the SEC will lose unless Goldman wants to pay up to make the bad publicity go away.

Here's why.

Read the SEC complaint. Read Goldman's denial. Observe the Venn diagram point where the two fact sets overlap in a significant way.

From Goldman: ACA had the largest exposure to the transaction, investing $951 million.

From the SEC: On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.

Think about that for a second. Whether it's $909 million, $951 million or $927.33311 million -- ACA, both sides agree, had a huge exposure to this deal. This was a $2 billion synthetic CDO. The German bank IBK, the other banner investor, only had $150 million of exposure (though to riskier tranches, true).

So ponder this a bit: why would ACA, whose duty was "portfolio selection agent," allow itself to be duped into stuffing the CDO sausage with the RMBS equivalent of rat tails and nose parts, if it was so hugely on the hook for the losses? Because consider this (all part of the SEC's own fact set in its complaint):

1. Paulson was a known short on subprime mortgages at this point. In 2007, the synthetic CDO was set up. Here's what happened a year earlier, according to the SEC:
Beginning in 2006, Paulson created two funds, known as the Paulson Credit Opportunity Funds, which took a bearish view on subprime mortgage loans by buying protection through CDS on various debt securities.
2. ACA wasn't some newbie from Canoobie when it came to setting up CDOs. The SEC tells us:
ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets.
And, what's more, ACA knew that Paulson was heavily involved in helping pick the securities for Abacus. Again, the SEC:
On February 5, 2007, an internal ACA email asked, “Attached is the revised portfolio that Paulson would like us to commit to – all names are at the Baa2 level. The final portfolio will have between 80 and these 92 names. Are ‘we’ ok to say yes on this portfolio?”
So get a load of this: You're ACA. You're among the best at structuring CDOs. You should be able to evaluate the mortgage bonds being assembled for the security pretty well. You should know how the risks work. You should also know what's going on in the larger market: who's bullish on these things, who's bearish (Paulson, Paulson, Paulson).

And you swallow risk on about half of a synthetic CDO that you let Paulson fill with, um, crap?

I think there's more to this story than meets the eye. My guess is that ACA is much more guilty (of stupidity or something else) than anyone is suggesting. I think (1) they got caught being idiots, essentially making a longish bet on residential mortgages by insuring the super-senior tranche of the CDO (this is the last one to take losses, when the defaults start to mount) (2) they may have been making a cynical play, on the bottom part of the synthetic CDO, letting Paulson pick some crap, thinking that the super-senior tranche would be amply protected if the housing market deflated a little OR they were simply grossly negligent and unbelievably stupid by not reviewing the bonds that a known subprime-mortgage short was stuffing into a CDO they were insuring almost half of.

So I'm doubtful the SEC will win this one, unless there's something big I'm missing. But I think the SEC's case will be the perfect stalking horse for achieving the financial system reform that we do need pretty badly -- so maybe it's not so bad to put Goldman on the rack for a year or two.

Saturday, April 10, 2010

Must-Read Story of the Morning

I've grown a little numb to the shocking revelations of this financial crisis, but every so often, a story will drop my jaw and make me go "wow."

Today's candidate: Pro Publica's The Magnetar Trade.

One of the authors, Jesse Eisinger, you may remember from the Wall Street Journal. I admired his stuff during his tenure there. He impressed me as a smart guy who liked to dig -- and then dig some more.

The "Magnetar trade" Yves Smith apparently has written about at some length in her new book Econned. She has mentioned Magnetar a few times on her blog, without going into too much detail (I'm sure her book does, and I'm dying to read it. Where's my review copy, dammit? :))

Right now, Magnetar looks like the scariest enabler of this subprime bubble I've seen so far. Of course Michael Lewis looked at the enabling role the shorts played in his The Big Short. But the players he interviews were small. And they were only indirectly feeding the subprime lunacy.

To wit: as long as there was appetite for products packed with questionable home mortgages (the securities known as CDOs, or collateralized debt obligations), his shorts would happily take the other side of the trade. But, as far as I can tell, they weren't actively instigating the creation of these crap-congested things.

Magnetar apparently had a more clever, and dangerous, approach. It offered to buy the lousiest portions of the CDOs (the so-called "equity tranches" -- they're not technically equity, but tend to behave like equity, thus the name). For a high risk investment, the equity tranche is like the canary in the coal mine, an early-warning signal of trouble ahead. Or, to mix animal metaphors: A fish rots from the head down. A CDO rots from the equity tranche up.

So the equity tranche can be hard to place, especially for a shaky investment. And if you can't place it, then the CDO just doesn't get created. So was Magnetar crazy?

Crazy like a fox, it turns out. Because the hedge fund turned around and shorted the entire CDO.

How it made money initially puzzled me, but as far as I could tell (Eisinger keeps it sketchy, presumably because he's writing for a general readership), Magnetar's equity investment was a rather small piece of the CDO, and since the hedge fund was going short on the entire security, it stood to gain more than it would lose. The disturbing brilliance of this strategy: while the CDO is "in the clover," making money, the income thrown off by Magnetar's equity tranche funds its short bet on the CDO. So the fund solved the classic short problem of "how long can I afford to hold out if this thing doesn't blow up soon?"

Read the story. I have a feeling that "Magnetar," before this a name that's been largely under the radar, is about to start attracting a little (unwanted) attention.

Update: My further reading leads me to believe that Magnetar was buying credit-default swaps against other slices of the CDO (larger slices than what it owned certainly), though not the entire CDO.

Friday, April 2, 2010

"So, My Friends, What is This ... 'Financial Innovation' You Speak Of?"

I've sometimes wondered what would happen if aliens teleported in to Washington and -- since they're aliens, of course, and naturally inquisitive -- began asking questions about anything and everything ("You peel it before you eat it? Ah yes, fascinating. So this Seinfeld, he is like a king to you?"). Eventually they'd get around to the financial crisis and how we plan to prevent such a disaster in the future. And our "wise men" (Geithner, Summers, with some bespectacled lackeys in tow) would patiently explain how we have to restrain bad behavior in the system, while not discouraging financial innovation.

At which point I imagine the lead alien, Zrigfryx, would scratch his ample, hairless dome and say:

"So, my friends, what is this ... 'financial innovation' you speak of?"

And if I were sitting in the back row of the small assembly -- lucky enough to have snagged one of the lottery tickets for the the limited seats available to the public -- I'd thrust my hand high in the air and say, "Oh, I know. I know. Let me answer that one."

Because I'm really starting to understand what this "financial innovation" is that the industry is so hellbent on preserving.

Just the other day, I happened to come across this Bloomberg story about how the investment bank Macquarie Group hired a guy by the name of Christopher Hogg. What particularly caught my eye was Hogg's signature accomplishment: "a developer of one of the most popular financing tools of the 1990s."

So what did he innovate? A way to finance infrastructure projects in poor countries, expanding GDP and turning generous profits at the same time, a real win-win? A more efficient pipeline for getting capital to struggling small U.S. businesses that deserve it?

Nope ... and nope. Hogg came up with "Mips." Cute name. Sounds like a Christmas stocking stuffer that turns into a runaway bestseller. Mips are actually "monthly income preferred securities." They're described as "a type of preferred stock that resembles debt." Now you may wonder, "Why the heck do we need these things? What greater purpose do they serve?"

Well, it's sort of like this: You look at "Mips" through your right eye and you see an equity, like a preferred share of stock. But you look at "Mips" through your left eye and you see a bond -- or debt. Mips involve special purpose vehicles (what doesn't these days, eh?) and an appropriate amount of complexity that I'll skip over here.

The bottom line is, after all the innovating, here's the payoff:
The shares provide benefits of stock because they’re considered equity by debt-rating companies while offering tax advantages of bonds because companies can deduct the dividend payments from income they report on their tax returns.
Got that? Basically Mips are a tax dodge. It's not that Mips have found a way to provide capital more efficiently or smartly ... in fact, in a world with an ideal tax code, Mips probably contribute to the less-efficient allocation of capital. Remember those CLO "innovations" that appeared to offer higher returns for the same risk as other similarly rated products? And how they started inefficiently sucking in capital and no one bothered to ask, "Hey, is the risk just being mispriced here or is there really a free lunch sitting out there on the sidewalk?"

Of course with Mips the rejoinder might be: the U.S. doesn't have an ideal tax code. To which one might reasonably reply: Okay, so which option is better (1) Try to fix the tax code (2) Let people exploit whatever loopholes they can find and the hell with it; happy Easter egg hunt!

Mips are hardly a rare example of loophole-seeking "innovation." Just this week in Dealbook, Andrew Ross Sorkin nailed another one: dividend payments that are embedded in derivatives so investors can avoid paying any taxes on the income. Nice huh? While you and I are faithfully mailing off checks to the IRS for our dividend taxes every year, certain wealthy people, helped along by "innovators," aren't playing by the same rules (note: this loophole is being closed, thank God).

I imagine that after I finish explaining all this to Zrigfryx, and he extends a spindly forefinger to scratch his dome again in puzzlement, he might say something like:

"So why is preserving all this financial innovation so important to you Americans?"

And I guess I'd say:

"Larry? Tim? You want to take that one?"